Mortgage Refinancing

Question 1

Why study mortgage debt

Answer 1

• Mortgages are the single largest household liability
• Important welfare consequences of household decisions, Fixed vs. adjustable, refinancing, default
• Important aggregate implications

Question 2

What are aggregate implications of mortgage financing

Answer 2

Effectiveness of monetary policy depends on household’s readiness to refinance

Question 3

What type of rates are available when taking out a mortgage

Answer 3

Fixed rate:
- Interest rate is fixed
- typically between 15 and 30 years
- Most popular in US and Germany
- When market rate falls it might make sense to refinance

Adjustable rate:
- Interest rate changes with market rate
- “Teaser rates”, lower in first years

Question 4

What is refinancing?

Answer 4

When rates fall hh have incentive to pay back old mortgage and take out a new one at lower interest rate. This is crucial for monetary policy, because it frees up hh disposable resources and therefore increases consumption.

Question 5

What is a mortgage spread

Answer 5

Difference between original and current market rate. Hh with positive spread can save

Question 6

Why don’t all households refinance, if they experience a positive spread above threshold?

Answer 6

Economic Constraints:
- Home equity decreases
- Income drops

Behavioral Factors:
- Non standard beliefs or preferences
- Complexity of the refinancing problem
- Costly attention or information gathering

Question 7

Study: Do behavioral factors play a role in refinancing?
What makes this study unique?

Answer 7

Yes, the study looks at a sample of pre-approved refinancing offers. Therefore declining such an offer points to behavioral factor contribution.

Question 8

Product Innovation in financial markets:
(Refinancing, auto)

Answer 8

Loosing out on lower rate mortgages is costly to hh. If aware, hh would have an incentive to pay a premium on automatically refinancing mortgages. In competitive mortgage market such a product would be expected. But there seems to be a lack of innovation

Question 9

Why is there a lack of innovation in the financial industry?
Model with borrower types.

Answer 9

Assume two types of borrowers:
- Naive borrowers (rational
- sophisticated borrowers (heuristic rats)
In perfect competition there are no profits. Therefore there is a cross subsidy from naive households to sophisticated ones that refinance.
Since naive households pay above market rate, lenders earn profits that they immediately give back to sophisticated households by providing them mortgages below market rate. The size of the cross subsidy (x) depends on the difference between the cost paid by naive and sophisticated hh. A new product would have to induce lower cost for the sophisticated hh than the old product, since the are the only ones willing to switch to the new product, assuming only sophisticated borrowers understand the new product. So the existence of naive hh is a natural barrier for innovation.

Question 10

Study: Refinancing cross-subsidies, Setup

Answer 10

UK mortgage market
- Adminsitrative date on outstanding mortgages
- structutal model of mortgage refinancing
- Compare status quo to single rate regime

Question 11

Study: Refinancing cross-subsidies, Results

Answer 11

Status quo features sizable cross subsidies from poor to rich across regions and individuals
- Discourages poorer households from homeownership
-> Regressive nature of cross-subsidies

Question 12

Taking Stock on Cross-Subsidies

Answer 12

• Empirics suggest large cross subsidies
• explains lack of financial innovation
• exacerbates consequences of naivety among the fraction of population

Question 13

What is the lock-in effect in housing markets

Answer 13

If you desire to move, you have to sell your house, pay back existing mortgage, find a new place take out a new mortgage on your new house. When interest rates increase during that time, this makes people reluctant to move. -> Lock in Effect

Question 14

What are economic consequences of the lock in effect

Answer 14

reduced mobility leads to misallocation of labour supply. Empirically there is a positive correlation between moving rate and mortgage spread

Question 15

Asymmetric effect of mortgage rates (lock-in)

Answer 15

Lower rates do not increase mobility, due to refinancing options.
Higher rates decrease mobility.

Question 16

Government policy that can help to alleviate refinancing frictions

Answer 16

• Insure individuals against insufficiently collateralized mortgages in case equity decreases.
• Send reminder letters to notice people about possible refinancing options. May help to reduce behavioral frictions due to inattention.